TIPRA highlights: new law generally favors taxpayers.

The following are highlights of domestic provisions in the 2005 Tax Increase Prevention and Reconciliation Act (TIPRA), signed into law May 17, 2006, affecting individuals, businesses and corporations.

Changes Affecting Individuals

Lower Tax Rates on Long-Term Capital Gains and Qualified Dividends

Under existing law, an individual's and other noncorporate taxpayer's "adjusted net capital gain" is taxed at a 15 percent top rate or, to the extent it would have been taxed at a 10 percent or 15 percent rate if it had been ordinary income, at a 5 percent top rate (or a 0 percent top rate for tax years beginning after 2007).

Adjusted net capital gain is the net capital gain for the tax year (the excess of net long-term capital gains over net short-term capital losses) less:

* Long-term capital gains taxed at a 28 percent top rate (gain on the sale of most collectibles and gain on the included portion of IRC Sec. 1202 small business stock); and

* Long-term capital gains taxed at a 25 percent top rate (unrecaptured Sec. 1250 gain attributable to real estate depreciation).

Adjusted net capital gain also includes qualified dividend income (discussed below).

Under existing law, these 15 percent, 5 percent and 0 percent rates on adjusted net capital gains would be in effect through 2008. Thereafter, rates ranging from 20 percent down to 8 percent would become effective.

The new law extends for two years, through tax years beginning before 2011, these lower rates on adjusted net capital gains.

Qualified Dividends: This type of income generally consists of dividends received during the tax year from domestic corporations and qualified foreign corporations--subject to holding period requirements and certain exceptions. It is treated as adjusted net capital gains and subject to the same favorable tax rates applicable to those gains.

Under existing law, this treatment would expire at the end of 2008. Thereafter, qualified dividends would be taxed at regular ordinary income tax rates.

The new law extends for two years, through tax years beginning before 2011, this favorable treatment of qualified dividends.

AMT Relief

Under existing law, the AMT exemption for individuals would be:

* $45,000 for joint returns, less 25 percent of AMTI exceeding $150,000 (no exemption if AMTI is $330,000 or more);

* $33,750 for unmarried individuals, less 25 percent of AMTI exceeding $112,500 (no exemption if AMTI is $247,500 or more); or

* $22,500 for married individuals filing separately, less 25 percent of AMTI exceeding $75,000 (no exemption if AMTI is $165,000 or more). However, AMTI for these taxpayers is increased by the lesser of $22,500 or 25 percent of the excess of AMTI (before this increase) over $165,000.

For tax years beginning in 2006, the new law provides the following exemptions:

* $62,550 for joint returns, less 25 percent of AMTI exceeding $150,000 (no exemption if AMTI is $400,200 or more);

* $42,500 for unmarried individuals, less 25 percent of AMTI exceeding $112,500 (no exemption if AMTI is $282,500 or more); or

* $31,275 for married individuals filing separately, less 25 percent of AMTI exceeding $75,000 (no exemption if AMTI is $200,100 or more). However, AMTI for these taxpayers is increased by the lesser of $31,275 or 25 percent of the excess of AMTI (ignoring the exemption reduction) over $200,100.

Nonrefundable Personal Credits: Under existing law, for 2006, nonrefundable personal credits, except the child credit, the adoption credit and the low income saver's credit could not exceed the excess of the regular tax over the tentative minimum tax.

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Under the new law, for tax years beginning in 2006, the combined total of these personal credits is limited to the regular tax less the foreign tax credit plus the AMT.

These personal credits are credits for:

* Dependent care (Sec. 21);

* The elderly and the permanently and totally disabled (Sec. 22);

* Mortgages (Sec. 25);

* Children (Sec. 24);

* Hope and Lifetime Learning (Sec. 25A);

* Adoption (Sec. 23); and

* Lower income savers (Sec. 25B).

Note: Unused nonrefundable personal credits cannot be carried to another tax year.

Kiddie Tax Age Increased to Children Under 18

Children subject to the Kiddie Tax pay tax at their parents' top marginal rates on the child's unearned income over $1,700 (for 2006) if that tax exceeds the tax the child would otherwise pay on that income.

Alternatively, parents can elect to include the child's gross income exceeding $1,700 (for 2006) in their returns.

Under the old law, the Kiddie Tax applied to children who did not attain age 14 before the close of the tax year if either parent was alive at the end of that tax year.

Under the new law, for tax years beginning after 2005, the Kiddie Tax applies to children not attaining age 18 before the close of the tax year if either parent is alive at the end of that year and the child does not file a joint return for that year.

AGI Ceiling Removed After 2009 for Regular IRA to Roth IRA Conversions 

Under existing law, regular IRAs can be converted to Roth IRAs if the taxpayer's modified AGI (excluding the conversion income) does not exceed $100,000 and the taxpayer is not a married individual filing a separate return (unless living apart from the spouse throughout the year of the conversion).

For tax years beginning after 2009, the new law eliminates this $100,000 modified AGI limitation on conversions of regular IRAs to Roth IRAs and also allows married individuals filing separately to make such conversions.

Under both the existing and new laws, conversion income is included in the return for the tax year which the funds are transferred or withdrawn from the regular IRA.

However, under the new law, for conversions during 2010, unless the taxpayer elects otherwise, no conversion income is taxable for 2010. Instead, half of that income is reportable for 2011 and half is reportable for 2012.

But income inclusion is accelerated if converted amounts are distributed before 2012. The determination of whether a distribution consists of converted amounts is made under the existing law's ordering rules dealing with the treatment of distributions from Roth IRAs.

In this situation, the amount included in income in the distribution year is increased by the distribution and the amount included in 2012 income (or 2011 and 2012 for 2010 distributions) is the lesser of half of the conversion income and the remaining untaxed conversion income.

Changes Affecting Businesses and Corporations

Enhanced Sec. 179 Expense Election Extended Through 2009

A taxpayer (except estates, trusts and certain noncorporate lessors) may elect under Sec. 179 to deduct as a current expense, instead of claiming depreciation, up to a specified amount of the cost of new or used tangible personal property placed in service during the tax year in the taxpayer's business.

The maximum annual deduction is $100,000 and is adjusted for inflation. For 2006, this amount is $108,000.

Under existing law, the maximum amount would decrease to $25,000 for property placed in service in tax years beginning after 2007.

This maximum amount also is reduced dollar-for-dollar by the amount of qualified property eligible for this election that is placed in service during the tax year which exceeds $400,000, adjusted for inflation. For 2006, this phase-out ceiling is $430,000.

Under existing law, the phase-out ceiling would decrease to $200,000 for property placed in service in tax years beginning after 2007.

Also, under existing law:

* Off-the-shelf computer software qualifies as Sec. 179 property--but only for tax years beginning before 2008; and

* A Sec. 179 election or revocation may be made, without IRS consent, on an amended return for the tax year to which the election or revocation applies, but only for tax years beginning before 2008.

The new law extends, for two years, to tax years beginning before 2010:

* The $100,000 expense election limitation and the $400,000 phaseout ceiling (as adjusted for inflation);

* The eligibility of off-the-shelf computer software for the Sec. 179 expense election; and

* The ability to elect or revoke Sec. 179 expense treatment without IRS consent.

Sec. 199 Deduction Changes

Sec. 199 authorizes a special deduction to reduce income from domestic manufacturing and other production activities equal to the lesser of:

* A specified percentage of the smaller of the taxpayer's: (1) qualified production activities income (QPAI) for the tax year or (2) taxable income (modified AGI for individuals), without this deduction, for that year (this percentage is 3 percent for tax years beginning in 2005 and 2006, 6 percent for tax years beginning in 2007-2009 and 9 percent thereafter); or

* Fifty percent of the employer's W-2 wages for the tax year. Under the old law, these wages are the total of all the amounts that must be reported on the employees' Forms W-2 for wages subject to withholding and elective deferrals.

For tax years beginning after May 17, 2006, the new law requires, for Sec. 199 purposes, that W-2 wages consist only of amounts properly allocable to domestic production gross receipts--which is used to determine QPAI.

S Corporations and Partnerships: Under the old law, in applying this W-2 wages limitation on the Sec. 199 deduction for an S corporation shareholder or a partner, these owners were treated as having W-2 wages for the tax year equal to the lesser of:

(1) The owner's allocable share of the entity's W-2 wages; or

(2) Two times the specified percentage described above (for example, 3 percent for tax years beginning in 2005 or 2006) of the QPAI allocated to the owner for that year.

For tax years beginning after May 17, 2006, the new law repeals computation No. 2 above. Thus, each owner is treated as having W-2 wages for the tax year only equal to the owner's allocable share of the entity's W-2 wages for that year.

Tax-Free Corporate Divisions

Active Business Requirement: One of the requirements for a Sec. 355 tax-free corporate division, such as a spin-off, is that the distributing corporation and any controlled corporation that it distributes must be engaged in the active conduct of a business.

Under the new law, for distributions after May 17, 2006 and before 2010, subject to a transitional rule, all members of a corporation's "separate affiliated group" are treated as one corporation for purposes of satisfying this active business test.

A separate affiliated group for any corporation is the affiliated group which would be determined for consolidated return eligibility [under Sec. 1504(a)] if that corporation were the common parent and the Sec. 1504(b) exclusions did not apply.

Consequently, the new law simplifies this active business test, thereby making it easier for corporate groups that use a holding company structure to qualify for tax-free divisions.

No Tax-Free Treatment for Disqualified Investment Corporations: Under the old law, there were no specific limits on investment assets that could be held by corporations desiring Sec. 355 tax-free treatment.

The new law, generally effective for distributions after May 17, 2006, denies this treatment where either the distributing or the distributed corporation is a "disqualified investment corporation" (DIC) immediately after the distribution (including any series of related transactions) and any person that did not hold 50 percent or more of either the voting power or value of stock in the DIC immediately before the distribution holds a 50 percent or more interest (by voting power or stock value) immediately after the distribution.

A DIC is any distributing or controlled corporation if the fair market value of the corporation's investment assets is two-thirds or more of the value of the corporation's total assets, or three-fourths of that value for distributions made before May 17, 2007.

The new law contains a detailed definition of investment assets.

Other Changes

Information Reporting for Tax-Free Bond Interest

The old law did not require information reporting for interest paid on tax-exempt bonds.

The new law requires such reporting for interest paid on these bonds after 2005.

Offers in Compromise (OICs)

For OICs submitted after July 15, 2006, the new law:

* Requires any lump-sum OIC (an offer of payment in five or less installments) to be submitted with a payment of 20 percent of the offer;

* Requires any periodic payment OIC to be submitted with a payment of the first proposed installment. Failure to pay subsequent installments due while the offer is evaluated by the IRS may be treated as a withdrawal of the offer;

* Provides that any OIC not accompanied by the required payment may be returned to the taxpayer as unprocessable;

* Treats an OIC as accepted if the IRS does not reject it within 24 months after it is submitted. For this purpose, any period during which any tax subject to this OIC is in dispute in any judicial proceeding is ignored in determining the expiration of this 24-month period;

* Provides that any assessed tax or interest and penalties imposed on a tax covered by an OIC subject to the above rules will be reduced by any user fee charged for the offer; and

* Authorizes regulations waiving any required payment (described above), consistent with the practices established under the Sec. 7122(d)(3) requirements.

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By Stuart R. Josephs, CPA 

Stuart R. Josephs, CPA has a San Diego-based Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax questions and problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at [phone] or [e-mail].